This book explores the potential for successful risk management to create the preconditions for larger risk management failure in the future. This may seem counter intuitive but his point is that a sense of danger can often be useful in that it promotes good risk management while a feeling of safety can promote behaviour that results in risk reemerging often in new and less obvious forms.
“Stability … may … be illusory, hiding the buildup of hidden risks or nurturing behavior that will bring the stability to an end”
“Our environment evolves, and successfully preventing one type of risk may simply funnel it elsewhere, to reemerge, like a mutated bacteria, in a more virulent fashion.” (Chapter 1)
Ip is not arguing that attempts to improve safety are pointless. All other things being equal, there are many ways in which systems and processes can be made safer, but all other things are rarely equal in the real world. The potential for unintended consequence is also increasingly being amplified by the complexity and inter linkages that characterise the environment, economy and financial systems we have created in the pursuit of growth and efficiency.
Ip also sounds a timely warning on the dangers of seeing adverse events as a morality plays in which the required response is simply to identify/punish the guilty and then devise more rules to stop the specific behaviour that caused the problem. The desire for justice and to punish the guilty is a deeply embedded human behaviour but the risk is that these distract attention from the underlying systemic issues that will see the risk manifest via another avenue.
Engineers versus Ecologists
In exploring the themes summarised above, Ip distinguishes two different philosophical approaches to the challenge of managing risk
- Engineers treat risk as a problem to be solved (or a process to be fixed) with the end goal of making the world safer and more stable
- Ecologists regard such efforts with suspicion because they tend to have unintended consequences than may be worse than the original problem to be solved.
The engineering approach has been the driving force in risk management for much of the last century but Ip argues that the analysis and solutions proposed by the ecologists are gaining more prominence as the limitations of the engineering approach become more apparent.
Early in the book, Ip uses the approach to economic management post WWII to illustrate his thesis. This is the familiar story of how economists treated the post war economy as a machine in which Keynesian fiscal policy could be used to fine tune the balance between growth, inflation and unemployment. In response to the failure of fiscal fine tuning, economists turned to monetary policy. For a while, this approach seemed to work sufficiently well that some economists pronounced the problem of managing the business cycle as solved.
Few people seemed to consider that there might be some downside to the “Great Moderation” (Ip cites Hyman Minsky as a notable exception). Clearly the GFC had many causes but Ip (correctly I think) highlights the extent to which efforts to insulate the economy from destabilising forces created an environment in which people progressively took on more and more risk that in turn created one of the foundations for a full blown crisis once the tide turned.
“By making the economy seem safer, the Great Moderation also changed attitudes about debt” Chapter 2
When safety fails
One of the more interesting ideas Ip explores is the consequences of learning that, something that you thought was safe, might not be. Ip argues that it does not matter whether the revised perception is correct (i.e. it does not matter if you are wrong in thinking that something is unsafe), what matters is that the prior assumption of safety is critical to creating one of the key preconditions for panic.
“…what makes it so damaging [is] not just the fact, but even more the perception that what should be safe, isn’t” (Chapter 3)
This insight draws on research by Gary Gorton exploring the causes of financial crisis and panic that argues:
- Firstly, that a central purpose of the financial system is to supply people with “safe assets” (i.e. an asset whose value is insulated from the uncertainty and risk that drives volatility in other financial assets like stocks and bonds)
- Secondly, financial innovation leads to the creation of new sorts of safe assets (some of which may not be really safe, or at least only safe under a limited set of circumstances)
- Third, panics occur when people come to believe (rightly or wrongly) that safe assets are no longer safe.
One implication of Gorton’s thesis is that more information (disclosure) is not the answer to the problem. The demand for safe assets is, by design, information insensitive so more information does not necessarily help and may even amplify concerns regarding solvency when it is based on marking to a market value which is over-reacting to the news or otherwise disfunctional. The foundation of a safe asset typically lies in some combination of government support (explicit or implicit) and a very senior position in the loss hierarchy (such as is the case with bank deposits which often have a preferred claim on the assets of the bank) that insulates their value from the information driving volatility in the price of other asset classes.
“A huge part of what the financial system does is try to create the fact – and at times the illusion – of safety. Usually, it succeeds; no one has lost money on an insured bank deposit. On those rare occasions when it fails, the result is panic.” (Chapter 3)
Risk thermostats and unintended consequences – First do no harm
Risk is complex; who knew? That said, we still encounter people proposing simple solutions that implicitly assume the system responds to the incentive and that is the end of the matter (like a school algebra problem).
Ip offers a number of examples that demonstrate that any effort to manage risk that does not take account of second and third round effects may end up being, at best, a waste of time and resources and, at worst, might even make the outcome worse. One of the first principles to recognise is that people tend to have a level of risk they are willing to tolerate and so anything that makes an activity less risky will tend to give them an incentive to reduce the margin of safety to reset their “risk thermostat”.
This principle is relatively well understood but there can also be unanticipated effects such as when efforts to make plane travel safer post September 11 resulted in increased traffic accident deaths as people used cars instead.
Striking the right balance between safety and disaster
Having established that the pursuit of safety can lead to behaviour that makes disaster more likely, Ip turns to the question what are we to do. To answer this he starts by examining the role of fear and risk.
“Fear is a two-edged sword. It keeps us from taking foolish risks that hurt us; but it can keep us from taking risks that could make us better off. And therein lies a dilemma. Sometimes it’s easy to tell bad risks from good. But most of the time, the distinction is not obvious.” (Chapter 7)
Ip uses the tension between the credit growth and systemic crises to explore this question. There is a substantial body of research that supports the conclusion that excessive credit growth increases the risk of a financial crisis. This analysis underpins the countercyclical capital buffer that the BCBS introduced as part of Basel III. On the other side of the equation, it is also well understand that financial liberalisation can support growth so the occasional bank failure might be seen as the price of growth. The key point is that there is a trade-off so setting the safety bar too high can be costly.
Ip does not pretend that there are easy answers to this dilemma (not even in hindsight) but recognising the tension is a good place to start, especially if you also understand where a proposed response sits on the engineering/ecological spectrum.
“Engineers will always be tempted to intervene, trusting in their ability to make it right; ecologists will always fear the unintended consequences of that intervention…the right choice changes with the circumstances, and it may not be obvious, even in hindsight. One broad lesson is that ecologists are right about micro-level risk: systems benefit from the lessons and resistance that small scale disasters nurture. Engineers are most valuable at staving off macro-level risk – that is, preventing large -scale catastrophe” (Chapter 8)
A foolproofer’s handbook
“Stability is destabilizing,” is what Hyman Minsky concluded about the tendency of stability in the financial system and economy to breed complacency and, ultimately, instability. But it is true of much more than that. Everything we do to make ourselves feel safer brings with it the inherent danger of amplifying our appetite for risk taking, the possibility that we’ll treat something dangerous as less dangerous, and the potential for panic when we discover we are wrong.” (Chapter 10)
Summing up the core themes I took away from this book:
- The pursuit of safety can be effective but the challenges arise when making an activity safe
- changes people’s behavior, offsetting some or all of the benefit
- or it causes the risky activity to migrate elsewhere.
- or risk pooling breaks down (e.g. when risks are correlated such as they are for the worst disasters)
- Moral hazard is not all bad
- We regard confidence as good and moral hazard as bad, but Ip sees them as two sides of the same coin.
- He argues that moral hazard can encourage us to take risks by protecting us from their consequences; we assume that’s reprehensible, but it enables society to do things and take risks that it otherwise wouldn’t, many of which make us better off.
- Financial panics begin when something people came to believe was 100 percent safe turns out not to be.
- People who crave certainty cannot tolerate even a slight increase in uncertainty, and so they flee not just the bad banks, the bad paper, and the bad country, but everything that resembles them, just as in food panics, millions of pounds of safe food are discarded along with the tainted.
- Attempting to make a system foolproof must also consider the price of freedom
- We really can limit danger and risk if we are willing to use rules, prohibitions, and jail time and if we worry that making an activity safer encourages more risk, ban the activity altogether
- But recognise that this takes us down the “nanny state” track
- The same tradeoff between safety and freedom applies to finance.
- The decades after 1934 are sometimes called “the quiet period” because they had no financial crises but this was in part because financial freedom was tightly circumscribed.
- We could have that financial system back again. All forms of lending and borrowing outside of regulated banks could be banned or severely restricted.
- Assume for a moment that this would work and that financiers could not find a way around these new rules. Would we accept these limitations? The jury is in, and the answer is no.
- Americans are content to slap controls on bankers but not on themselves. Consider, for example, that after the crisis, regulators considered requiring a 20 percent down payment for most mortgages. This would have guaranteed less severe housing busts, because home prices would have to fall 20 percent before the home was no longer worth more than the mortgage. But bankers, home builders, and consumer advocates, who are normally at one another’s throats, united against the idea, complaining (correctly) that it would lock millions of potential buyers out of the housing market. The regulators backed down. For many aspiring homeowners, leverage equals freedom.
- If we are going to erect rules and barriers, Ip argues that they should
- limit the damage of risk taking with as few unintended consequences as possible and
- work no matter the threat (relying on the ability to anticipate and adjust to threats as they arise is a strategy prone to failure if the threats are by nature unexpected or unprecedented)
- Ip concludes that one remedy that seems to work everywhere is “space” and uses “capital” in a financial context to illustrate his argument
I don’t agree with everything in the book. In particular, I think the benefits that Ip attributes to moral hazard can be secured without just accepting it as the price of having a confident, innovative, risk taking economy. There is no room here to go into why I believe this but the essence of my position is that the value of money (by which I mostly mean bank deposits) can be protected by a combination of strong capital standards, bail-in of certain bank liabilities, depositor preference in the bank loss hierarchy and a capped deposit insurance scheme. Limited liability company structures seem to be sufficient to protect shareholders. I also think there are issues with the way he cites capital as a cure all for risk in banking.
That said, the core themes of the book reflected in the following quotes ring very true with me
“Foolproof safety is a moving target, with competing prescriptions from engineers and ecologists. Engineers satisfy our desire for control, for eliminating the anxiety that comes with uncertainty and the unknown. They fulfill civilization’s need to act, to do something, to take the existing chaotic mess and make it better.”
“But we should not ask too much of them. We can make disaster and crisis less frequent and more survivable, but we won’t end either. Nor should we want to. Periodic crisis is the price we pay for an economic system that encourages, and rewards, risk.”
“As ecologists know, forests, bacteria, and economies are irrepressibly adaptable. Every step we take to suppress the risks they present in the short term will provoke some other, offsetting step whose consequences will only show up in the long term.”
“…it’s the nature of risk to find the vulnerabilities we missed, to hit when least expected, to exploit the very trust in safety we so assiduously cultivate with all our protection and insurance. The right tradeoff between risk and stability will maximize the units of innovation we get per unit of instability.”
“The engineers and the ecologists in their different ways embody the best of civilization. We do not have to side with either, but we can take the best of both. Our goal should be to eliminate big disasters, not small ones, to accept a bit more risk and instability today in return for more reward and stability in the long run.” (Chapter 11)